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2.3 Definition of a derivative
Publication date: 29 Nov 2020
us Derivatives & hedging guide 2.3
ASC 815-10-15-83 defines a derivative instrument.
A derivative instrument is a financial instrument or other contract with all of the following characteristics:
- Underlying, notional amount, payment provision. The contract has both of the following terms, which determine the amount of the settlement or settlements, and, in some cases, whether or not a settlement is required:
- One or more underlyings
- One or more notional amounts or payment provisions or both.
- Initial net investment. The contract requires no initial net investment or an initial net investment that is smaller than would be required for other types of contracts that would be expected to have a similar response to changes in market factors.
- Net settlement. The contract can be settled net by any of the following means:
- Its terms implicitly or explicitly require or permit net settlement.
- It can readily be settled net by a means outside the contract.
- It provides for delivery of an asset that puts the recipient in a position not substantially different from net settlement.
The key terms within the definition are (1) underlying, (2) notional amount, (3) payment provision, (4) initial net investment, and (5) net settlement.
2.3.1 Underlying
ASC 815-10-15-88 defines an underlying.
An underlying is a variable that, along with either a notional amount or a payment provision, determines the settlement amount of a derivative instrument. An underlying usually is one or a combination of the following:
a. A security price or security price index
b. A commodity price or commodity price index
c. An interest rate or interest rate index
d. A credit rating or credit index
e. An exchange rate or exchange rate index
f. An insurance index or catastrophe loss index
g. A climatic or geological condition (such as temperature, earthquake severity, or rainfall), another physical variable, or a related index
h. The occurrence or nonoccurrence of a specified event (such as a scheduled payment under a contract).
An underlying may be the price or rate of an asset or liability but is not the asset or liability itself. Accordingly, the underlying will generally be the referenced rate or index that determines whether or not the derivative has a positive or negative value. For example, the underlying in a contract that provides the holder an option to purchase a security is the price of the security.
ASC 815-10-55-77 through ASC 815-10-55-83 provides an example of determining an underlying if a contract contains a fixed element and variable element. The example illustrates that an agreement between parties to transact (a) at a fixed price in the future, (b) at the prevailing market rate, or (c) at the prevailing market rate plus or minus a fixed basis differential all contain an underlying and meet the definition of a derivative.
An underlying equal to the prevailing market rate will result in the derivative instrument having little to no value as the transaction will happen at the market rate.
2.3.2 Notional amount
ASC 815-10-15-92 defines a notional amount.
Excerpt from ASC 815-10-15-92
A notional amount is a number of currency units, shares, bushels, pounds, or other units specified in the contract. Other names are used, for example, the notional amount is called a face amount in some contracts.
The notional amount generally represents the second half of the equation that determines the settlement amount under a derivative. Accordingly, the settlement amount of a derivative is often determined by the interaction of the notional amount and the underlying. This interaction may consist of simple multiplication, or it may involve a formula with leverage factors or other constants.
2.3.2.1 Requirements contract
A requirements contract is defined in ASC 815-10-55-5 as a contract that requires one party to the contract to buy the quantity needed to satisfy its needs. Although this type of contract is entered into to meet the needs of one of the parties to the contract, it may meet the definition of a derivative. A reporting entity will need to analyze the terms of the requirements contract to determine whether it is a derivative instrument; that determination depends in part on whether the contract has a notional amount.
The requirements contract guidance in ASC 815-10-55-5 through ASC 815-10-55-7 is only applicable in cases when the seller is to supply all of the purchaser’s needs and the purchaser cannot buy excess units for resale. In a requirements contract, the contract has a notional amount if it includes a reliable means to determine a quantity. Settlement and default provisions may provide that means (e.g., a specified minimum delivery amount based on three-year historical average usage).
In evaluating a requirements contract, there is no notional amount unless either the buyer or seller has the right or ability to enforce a quantity at a specified level or the seller is compelled to perform due to a material penalty provision. Provisions supporting the notional amount should be in the contract itself or a legally-binding side agreement.
When the notional amount is not determinable, making the quantification of an amount highly subjective and relatively unreliable (e.g., if a contract does not contain settlement and default provisions that specifically reference quantities or provide a formula based on historical usage), the contracts are considered to have no notional amount for purposes of applying ASC 815.
ASC 815-10-55-5 through ASC 815-10-55-7 provides guidance on how to evaluate whether a requirements contract has a notional amount. See UP 3.2.1.1 for additional information on the determination of the notional amount in requirements contracts.
2.3.3 Payment provision
In lieu of specifying a notional amount, some derivatives contain a payment provision, which is defined in ASC 815-10-20.
Definition from ASC 815-10-20
Payment Provision: A payment provision specifies a fixed or determinable settlement to be made if the underlying behaves in a specified manner.
For example, a contract might specify that a $5 million payment will be made if interest rates increase by 200 basis points or if hurricane damage in Florida exceeds $300 million during the next 12 months; the contract has a payment provision even though the settlement of the contract is driven by the behavior of the underlying.
2.3.4 Initial net investment
Many derivative-like instruments do not require an initial cash outlay. Others may require an initial payment as compensation for time value (e.g., a premium on an option) or for terms that are more favorable than market conditions (e.g., a premium on an in-the-money option).
ASC 815-10-15-94 through ASC 815-10-15-98 defines a derivative as either a contract that does not require an initial net investment or a contract that requires an initial net investment that, when adjusted for the time value of money, is less (“by more than a nominal amount”) than the initial net investment that would be required to acquire the asset or incur the obligation related to the underlying.
A derivative does not satisfy this criterion if the initial net investment is equal to the notional amount (or the notional amount plus a premium or minus a discount) or is determined by applying the notional amount to the underlying. See ASC 815-10-55-150, Case A, for an example of this concept.
Question DH 2-1 discusses what is considered more than a nominal amount.
Question DH 2-1
What amount is considered more than a nominal amount?
What amount is considered more than a nominal amount?
PwC response
The FASB did not provide a bright line for what constitutes a nominal amount. We believe its intention is for an initial net investment that is less than 90% of the amount that would be exchanged to acquire the asset or incur the obligation related to the underlying to be considered “less, by more than a nominal amount.”
ASC 815-10-55-166 through ASC 815-10-55-168 provide an example that illustrates how to determine the meaning of “less by more than a nominal amount.” The determination should be made on a case by case basis considering the facts and circumstances.
Some derivatives might require a mutual exchange of assets at a contract’s inception, in which case the initial net investment would be the difference between the fair values of the assets exchanged. An exchange of currencies of equal fair values (e.g., in a currency swap contract) is not considered an initial net investment; it is the exchange of one kind of cash for another kind of cash of equal value.
2.3.5 Net settlement
Another key concept in the definition of a derivative is whether a contract can be settled net, which generally means that a contract can be settled at its maturity through an exchange of cash, instead of through physical delivery of the referenced asset. A contract may be considered net settled when its settlement meets one of the criteria in ASC 815-10-15-99.
A contract fits the description in paragraph 815-10-15-83(c) if its settlement provisions meet criteria for any of the following:
a. Net settlement under contract terms [DH 2.3.5.1]
b. Net settlement through a market mechanism [DH 2.3.5.2]
c. Net settlement by delivery of derivative instrument or asset readily convertible to cash [DH 2.3.5.3]
Most futures, forwards, swaps, and options are considered derivatives because (1) their contract terms call for a net cash settlement, or (2) a mechanism exists in the marketplace that makes it possible to enter into closing contracts with a net cash settlement. Also included under the definition of a derivative are commodity-based contracts that permit settlement through the delivery of either a commodity or cash (e.g., commodity futures, options, swap contracts), commodity purchase and sales contracts that require the delivery of a commodity that is readily convertible to cash (e.g., wheat, oil, gold), and loan commitments from the issuer’s (lender’s) perspective that relate to the origination of mortgage loans that will be held for sale.
Question DH 2-2 discusses whether a forward commitment meets the definition of a derivative.
Question DH 2-2
If a reporting entity enters into a forward commitment that obliges it to transfer financial assets to a securitization structure for a specified period (e.g., a credit card securitization with a term of 60 months), does the forward commitment meet the definition of a derivative?
If a reporting entity enters into a forward commitment that obliges it to transfer financial assets to a securitization structure for a specified period (e.g., a credit card securitization with a term of 60 months), does the forward commitment meet the definition of a derivative?
PwC response
Generally, no. Although the commitment has gains or losses based on changes in interest rates, it does not have a net settlement provision or a means outside the contract to meet the net settlement criterion. A commitment of this type is fulfilled by the transfer of financial assets, such as credit card receivables. Because the financial assets to be delivered are not readily convertible to cash, the commitment does not meet the net settlement criterion. If, however, a market develops, as set out in ASC 815-10-15-118, for the underlying financial instruments, these commitments could meet the net settlement criterion.
2.3.5.1 Net settlement under contract terms
ASC 815-10-15-100 defines this form of net settlement.
Excerpt from ASC 815-10-15-100
In this form of net settlement, neither party is required to deliver an asset that is associated with the underlying and that has a principal amount, stated amount, face value, number of shares, or other denomination that is equal to the notional amount (or the notional amount plus a premium or minus a discount). (For example, most interest rate swaps do not require that either party deliver interest-bearing assets with a principal amount equal to the notional amount of the contract.) Net settlement may be made in cash or by delivery of any other asset (such as the right to receive future payments…), whether or not that asset is readily convertible to cash.
Contractual net settlement will most often be made in cash, but there are other forms of settlement. Some of the other forms are discussed in the following sections.
Net share settlement
Net share settlement is a form of net settlement in which the party in the loss position delivers shares with a fair value equal to the loss to the party in the gain position. This is commonly referred to as “cashless exercise,” and it meets the net share settlement criterion in ASC 815-10-15-102. If either counterparty could net share settle the contract, then it would meet the net settlement criterion —regardless of whether the net shares are readily convertible to cash, as described in ASC 815-10-15-119.
The issuer of a contract that meets the definition of a derivative because of a net share settlement provision may qualify for the scope exception for certain contracts involving an entity’s own equity in ASC 815-10-15-74(a). See DH 3.3 for information on this scope exception.
Net settlement in the event of nonperformance or default
ASC 815-10-15-103 discusses how contracts that contain penalties for nonperformance or default meet the net settlement criterion if the contract’s default provisions call for net settlement upon such nonperformance or default. As a result, reporting entities need to evaluate all default provisions and termination penalties when determining whether a contract includes net settlement provisions.
Figure DH 2-1 summarizes key considerations in evaluating default provisions. See UP 3 for additional information.
Figure DH 2-1 Evaluating whether default provisions constitute net settlement
Net settlement provisions |
Not net settlement provisions |
|
|
Symmetrical default provisions
A symmetrical default provision requires an entity to pay a penalty for nonperformance that equals the change in the price of the items that are the subject of the contract. It might be considered a net settlement provision, depending on the specifics of the contract. For example, a liquidating-damages clause that stipulates that if the seller fails to deliver a specified quantity of a particular commodity or buyer fails to accept the delivery of that commodity, the party in an unfavorable position must pay the other party an amount equal to the difference between the spot price on the scheduled delivery date and the contract price, regardless of which party defaulted.
Asymmetrical default provisions
An asymmetrical default provision requires the defaulting party to compensate the nondefaulting party for any incurred loss, but does not allow the defaulting party to benefit from favorable price changes.
An asymmetrical default provision does not constitute net settlement. However, the presence of asymmetrical default provisions applied in contracts between the same counterparties indicates the existence of an agreement between those parties that the party in a loss position may elect the default provision, thus incorporating a net settlement provision within the contract.
In addition, a pattern of settlements outside of physical delivery would call into question whether the provision serves as a net settlement mechanism under the contract. It would also call into question whether the full contracted quantity will be delivered under this and similar contracts.
Net settlement of a contract designated as normal purchases and normal sales would result in a tainting event that would need to be evaluated to determine the impact on the contract itself and other contracts similarly designated as normal. See DH 3.2.4 for information on the normal purchases and normal sales exception.
Penalties for nonperformance
A fixed penalty for nonperformance is not considered a net settlement provision because the amount does not vary with changes in the underlying.
As discussed in ASC 815-10-15-103(c), a variable penalty for nonperformance is not a form of net settlement if that penalty also contains an incremental fixed penalty in an amount that would be expected to act as a disincentive for nonperformance throughout the term of the contract.
Structured settlement
In a structured payout, the payout of the net gain or loss is not made immediately. Instead, the holder may receive a financial instrument (e.g., a receivable) whose terms pay out the gain or loss over time.
As discussed in ASC 815-10-15-104, a contract that provides for a structured payout of its gain or loss meets the characteristic of net settlement if the fair value of the cash flows to be received or paid are approximately equal to the amount that would have been received or paid if the contract had provided for an immediate payout.
However, as discussed in ASC 815-10-15-105, a contract cannot be net settled if the holder is required to invest funds in, or borrow funds from, the other party to obtain the benefits of a gain on the contract over time as a traditional adjustment of either the yield on the amount invested or the interest element on the amount borrowed. A fixed-rate mortgage commitment is an example of this type of contract. To benefit from the gain on a loan commitment (due to an increase in interest rates), the holder of the loan commitment must borrow money from the lender.
In contrast, when a contract requires an investment of funds in, or borrowing of funds from, the other party so that the party in a gain position under the contract obtains the value of that gain only over time through a nontraditional or atypical yield, net settlement does exist because the settlement is in substance a structured payout of the contract’s gain. ASC 815-10-55-21 illustrates this concept.
Excerpt from ASC 815-10-55-21
For example, if a contract required the party in a gain position … to invest $100 in the other party’s debt instrument that paid an abnormally high interest rate of 5,000 percent per day for a term whose length is dependent on the changes in the contract’s underlying, an analysis of those terms would lead to the conclusion that the contract’s settlement terms were in substance a structured payout of the contract’s gain and thus that contract would be considered to have met the characteristic of net settlement ...
Net settlement of debt through exercise of an embedded put or call option
Settlement of a debtor’s obligation to a creditor through exercise of a put or call option embedded within the debt meets the net settlement criterion because neither party is required to deliver an asset that is associated with the underlying. See DH 4.4.3 for additional information.
2.3.5.2 Net settlement through a market mechanism
Net settlement can also occur when one of the parties to a contract is required to deliver an asset associated with the underlying, but there is an established market mechanism that facilitates net settlement outside the contract. That is, there is a market for the contract itself. For example, an exchange that offers a ready opportunity to sell the contract or to enter into an offsetting contract is a market mechanism.
ASC 815-10-15-118 requires that the assessment of whether a market mechanism exists be performed at inception and on an ongoing basis throughout a contract’s life.
Market mechanisms may have different forms. Many derivatives are actively traded and can be closed or settled before the contract’s expiration or maturity by net settlement in active markets. Reporting entities should interpret the term market mechanism broadly to include any institutional arrangement or other agreement having the requisite characteristics. For example, any institutional arrangement or over-the-counter agreement that permits either party to (1) be relieved of all rights and obligations under the contract, and (2) liquidate its net position in the contract without incurring a significant transaction cost is considered a net settlement. Regardless of its form, an established market mechanism must have all of the primary characteristics in ASC 815-10-15-111.
Excerpt from ASC 815-10-15-111
The term market mechanism is to be interpreted broadly and includes any institutional arrangement or other agreement having the requisite characteristics. Regardless of its form, an established market mechanism must have all of the following primary characteristics:
a. It is a means to settle a contract that enables one party to readily liquidate its net position under the contract. A market mechanism is a means to realize the net gain or loss under a particular contract through a net payment. Net settlement may occur in cash or any other asset. A method of settling a contract that results only in a gross exchange or delivery of an asset for cash (or other payment in kind) does not satisfy the requirement that the mechanism facilitate net settlement.
Additional factors that would indicate that the settlement method enables one party to readily liquidate its net position include markets that provide access to potential counterparties regardless of a seller’s size or market position, and if the risks assumed by a market maker as a result of acquiring a contract can be transferred by a means other than by repackaging the original contract into a different form.
Excerpt from ASC 815-10-15-111
b. It results in one party to the contract becoming fully relieved of its rights and obligations under the contract. A market mechanism enables one party to the contract to surrender all future rights or avoid all future performance obligations under the contract. Contracts that do not permit assignment of the contract from the original issuer to another party do not meet the characteristic of net settlement through a market mechanism. The ability to enter into an offsetting contract, in and of itself, does not constitute a market mechanism because the rights and obligations from the original contract survive. The fact that an entity has offset its rights and obligations under an original contract with a new contract does not by itself indicate that its rights and obligations under the original contract have been relieved. This applies to contracts regardless of whether either of the following conditions exists:
1. The asset associated with the underlying is financial or nonfinancial.
2. The offsetting contract is entered into with the same counterparty as the original contract or a different counterparty (unless an offsetting contract with the same counterparty relieves the entity of its rights and obligations under the original contract, in which case the arrangement does constitute a market mechanism). (Example 6 [see paragraph 815-10-55-91] illustrates this guidance.)
Generally, an offsetting contract does not replace an original contract’s legal rights and obligations. See ASC 815-10-55-91 through ASC 815-10-55-98 (Example 6: Net Settlement Through a Market Mechanism—Ability to Offset Contracts) and ASC 815-10-15-117.
Additional factors that indicate that a party to the contract can be fully relieved of its rights and obligations under the contract include:
- Multiple market participants that are willing and able to enter into a transaction at market prices to assume the seller’s rights and obligations under a contract
- Sufficient liquidity in the market for the contract, as indicated by the transaction volume and a relatively narrow and observable bid/ask spread
Excerpt from ASC 815-10-15-111
c. Liquidation of the net position does not require significant transaction costs. For purposes of assessing whether a market mechanism exists, an entity shall consider transaction costs to be significant if they are 10 percent or more of the fair value of the contract. Whether assets deliverable under a group of futures contracts exceeds the amount of assets that could rapidly be absorbed by the market without significantly affecting the price is not relevant to this characteristic. The lack of a liquid market for a group of contracts does not affect the determination of whether there is a market mechanism that facilitates net settlement because the test focuses on a singular contract. An exchange offers a ready opportunity to sell each contract, thereby providing relief of the rights and obligations under each contract. The possible reduction in price due to selling a large futures position is not considered to be a transaction cost.
d. Liquidation of the net position under the contract occurs without significant negotiation and due diligence and occurs within a time frame that is customary for settlement of the type of contract. A market mechanism facilitates easy and expedient settlement of the contract. As discussed under the primary characteristic in (a), those qualities of a market mechanism do not preclude net settlement in assets other than cash.
Readily-obtainable binding prices, standardized documentation and settlement procedures, minor negotiation and structuring requirements, and nonextensive closing periods are all indicators that the particular market mechanism provides for easy and expedient settlement of the contract.
Question DH 2-3 asks whether an entity should determine if a market mechanism exists on an individual contract basis.
Question DH 2-3
Should a reporting entity determine whether a market mechanism exists on an individual contract basis?
Should a reporting entity determine whether a market mechanism exists on an individual contract basis?
PwC response
Yes. This assessment should be performed on an individual contract basis, not on an aggregate holdings basis. The lack of a liquid market for a group of contracts does not affect whether a market mechanism exists that facilitates net settlement for an individual contract within that group.
2.3.5.3 Net settlement delivery of an asset readily convertible to cash
Delivery of an asset that is readily convertible to cash puts the receiving party in a position that is equivalent to a net settlement.
An example of a contract with this form of net settlement is a forward contract that requires delivery of an exchange-traded equity security. Even though the number of shares to be delivered is the same as the notional amount of the contract and the price of the shares is the underlying, an exchange-traded security is readily convertible to cash. Another example is a swaption—an option to require delivery of a swap contract, which is a derivative instrument.
When a contract is net settled, neither party accepts the risks and costs customarily associated with owning and delivering the asset associated with the underlying (e.g., storage, maintenance, resale costs). If the asset to be delivered is readily convertible to cash, those risks are minimal. Therefore, the parties should be indifferent as to whether there is a gross physical exchange of the asset or a net settlement in cash.
The ASC Master Glossary defines “readily convertible to cash.”
Definition from ASC Master Glossary
Readily Convertible to Cash: Assets that are readily convertible to cash have both of the following:
- a. Interchangeable (fungible) units
- Quoted prices available in an active market that can rapidly absorb the quantity held by the entity without significantly affecting the price.
Based on this concept, examples of assets that are readily convertible to cash include:
- A security or commodity that is traded in a deep and active market
- A unit of foreign currency that is readily convertible to the functional currency of the reporting entity
Conversely, securities that are not actively traded, or an unusually large block of thinly traded securities, would not be considered readily convertible to cash in most circumstances, even though the owner might be able to use such securities as collateral in a borrowing arrangement. Therefore, an asset (whether financial or nonfinancial) is considered to be readily convertible to cash if the net amount of cash that would be received from a sale of the asset in an active market is equal to or not significantly less than the amount the entity would typically have received under a net settlement provision. Parties generally should be indifferent as to whether they exchange cash or the assets associated with the underlying.
A reporting entity must assess the estimated costs that would be incurred to immediately convert the asset to cash. If those costs are significant, then the asset is not considered readily convertible to cash and would not meet the definition of net settlement. Estimated conversion costs are considered significant if they are 10% or more of the gross sales proceeds (based on the spot price at the inception of the contract) that would be received from the sale of those assets in the closest or most economical active market.
ASC 815-10-55-99 through ASC 815-10-55-110 (Example 7: Net Settlement—Readily Convertible to Cash—Effect of Daily Transaction Volumes) illustrates how to assess whether contracts that can be contractually settled in increments meet the net settlement criterion. A reporting entity must determine whether or not the quantity of the asset to be received from the settlement of one increment is considered readily convertible to cash. If the contract can be settled in increments and those increments are considered readily convertible to cash, the entire contract meets the definition of net settlement.
Question DH 2-4 discusses whether contracts that can be contractually settled in increments meets the net settlement criterion.
Question DH 2-4
A reporting entity has an option to purchase one million shares of a publicly-traded stock, which can be exercised in increments of 25,000 shares. To determine whether the shares can be rapidly absorbed in the market without significantly affecting the price, should the reporting entity base its assessment on the exercise of a 25,000 share increment?
A reporting entity has an option to purchase one million shares of a publicly-traded stock, which can be exercised in increments of 25,000 shares. To determine whether the shares can be rapidly absorbed in the market without significantly affecting the price, should the reporting entity base its assessment on the exercise of a 25,000 share increment?
PwC response
Yes. When determining whether the shares can be rapidly absorbed in the market without significantly affecting the price, the reporting entity should base its assessment on the exercise of the smallest increment (25,000 shares), not on the entire option’s notional amount (one million shares).
Considerations for warrants
As discussed in ASC 815-10-15-131, publicly-traded shares of stock are not considered readily convertible to cash when they are received through the exercise of a warrant issued by a reporting entity on its own stock and cannot be sold or transferred (other than in connection with being pledged as collateral) for a period of 32 days or more from the date the warrant is exercised.
2.3.6 Reassessing a contract meeting the definition of a derivative
Whether a contract meets the definition of a derivative and, if it does, whether it qualifies for a scope exception should be revisited each reporting period, unless otherwise provided in ASC 815-10-15. For example, ASC 815-10-15-103(c) states that contracts with both variable and fixed nonperformance penalties should be evaluated only at inception to determine whether the penalties constitute net settlement.
Contract terms or customary practices may change, affecting the determination of whether a particular contract meets the definition of a derivative instrument or qualifies for a scope exception.
A contract that subsequently meets the definition of a derivative (or no longer qualifies for a scope exception) should be carried at fair value prospectively from the time it is determined to be a derivative.
Question DH 2-5 asks how a reporting entity accounts for a contract that was not a derivative at inception but later meets the definition of a derivative.
Question DH 2-5
How should a reporting entity account for a contract that was not a derivative contract at its inception but later meets the definition of a derivative?
How should a reporting entity account for a contract that was not a derivative contract at its inception but later meets the definition of a derivative?
PwC response
ASC 815-10-15-3 requires a contract that meets the definition of a derivative subsequent to its acquisition to be immediately recognized as a derivative. It should be recorded at its then current fair value, with the offsetting entry recorded in earnings. Subsequently, the contract should be recorded at its fair value each period with changes in its fair value recorded through earnings unless the requirements for hedge accounting are met.
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